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Output Expenditure Model

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Output Expenditure Model

There are times in the economy when companies are overproducing or underproducing. Why does this happen? Don't companies produce the amount that they are expected to sell? How does production take place, and how does this affect our economy? You'll find out the answers to these questions and much more if you go right ahead and get to the bottom of this article!

Output-Expenditure Model Definition

Let's dive right into the output-expenditure model definition. Knowing whether an economy produces too much or too little output concerning a demand is essential in macroeconomics.

The output-expenditure model compares aggregate expenditures (total demand) to gross domestic product (real GDP).

Real GDP represents the total output in the economy. It is the full value of all final goods and services produced within a nation, adjusted for inflation.

It's important to note that the total amount of output produced in the economy is not always consumed on an aggregate level.

The output expenditure model considers the aggregate spending on four main components of the aggregate demand: consumer spending, investment spending, government expenditure, and net exports.

Check out our article on Aggregate Demand for a detailed explanation!

We also have one on Aggregate Demand Curve if you want to know all its ins and outs!

This is the equation on which the output expenditure model is based:

According to this model, the revenue generated by the consumer sector is spent on the various products and services consumed by households.

These personal consumption expenditures consist of nearly everything consumers purchase, including food, rent, and almost anything else!

The investment sector, often known as the business sector, is responsible for the spending of the money generated by the economy on workers, factories, equipment, inventories, and other economic investment items. These costs consider the aggregate value of all capital goods produced by the economy over the given year.

The government allocates its revenue to a wide variety of priorities, such as national defense, social security, interest payments on the national debt, health care, and the construction of highways. The only significant expenditure made by the government that is not accounted for in total output is transfer payments. This is because the money is redirected to be used by others to purchase goods and services.

We have an entire article covering "The Government Budget" in detail. Check it out!

The international market is responsible for purchasing a significant portion of the commodities and services that contribute to the United States' gross domestic product (GDP).

These include agricultural products, tractors, aircraft, and insurance. In exchange, the foreign market sells goods, such as automobiles from Japan, steel from Korea, and footwear from Brazil, to customers in the United States.

The purchases made by the international sector are considered to be "net exports of goods and services."

GDP Output Expenditure Model

Using the GDP Output-Expenditure Model, we can determine equilibrium GDP (also called equilibrium real GDP). This is the output level at which all output that is produced is consumed.

The real GDP represents the total value of goods and services produced in the economy and is adjusted for the price level.

Figure 1 shows the output expenditure model. This graph will help you better understand and interpret the model.

The Output Expenditure Model Output Expenditure Model Diagram StudySmarter Figure 1. Output Expenditure Model Diagram, StudySmarter Originals

On the vertical axis in Figure 1 above, you have the aggregate expenditure. On the horizontal axis, you have the real GDP. The diagram consists of the aggregate expenditure line and the 45-degree line, representing the real GDP.

The aggregate expenditure lines point to the level of aggregate consumption. The 45-degree line represents the real GDP. This is a straight line that starts from the origin and continues outwards. Note that the level of production (horizontal axis) and level of consumption (vertical axis) is equal throughout this line. The reason is that the total output produced equals consumption at every point along the line.

There is also a potential GDP line.

The potential GDP line refers to the total possible production if the economy uses all of its resources efficiently.

The potential GDP and its importance for the economy are covered in detail in our article: AD-AS model.

Have a look at it!

The point where the aggregate expenditures (AE) line intersects the 45-degree line forms the equilibrium real GDP in the output expenditure model. That means that the economy's total spending and production are equal. However, as you might see from the graph, these two lines are not always equal to each other.

When output, represented by the 45-degree income line, is below aggregate expenditures (AE), an inflationary gap occurs due to aggregate demand (synonymous with AE) being greater than supply. Firms will increase their output to meet the higher demand.

When output is above AE, a recessionary gap occurs due to supply being greater than demand. Firms will restrict their output to avoid an accumulation of unsold inventory.

Aggregate Expenditure Output Model

The aggregate expenditure output model aims to show the economic relationship between real GDP and aggregate expenditure.

Aggregate expenditures (AE) equal the total spending in the macroeconomy. They are usually represented by adding the four sectors of GDP: consumption (C), gross private domestic investment (I), government expenditures (G), and net exports (X-M).

These components are covered in much more detail in our Aggregate Demand article. Take a look at it!

Aggregate expenditure is not always equal to the 45-degree line representing the economy's real GDP. The reason is that aggregate expenditure depends on the Marginal Propensity to Consume (MPC).

The marginal propensity to consume shows the part of income households consume rather than save.

The MPC formula is as follows:

If all marginal (additional) income is consumed, then MPC equals 1. At this MPC, the slope of the AE line is equal to 45 degrees, and all output will be consumed. That means there is no output level that will cause inventories to be used up (inflation) or build up (recession).

However, if MPC is any ratio less than one, the AE line will have a slope less than 45 degrees. It will cross the 45-degree income line at some point, revealing equilibrium GDP.

Economists and firms must measure society's marginal propensity to consume (MPC) and aggregate expenditures to avoid overproduction or underproduction.

Economic researchers, including government agencies like the Federal Reserve, Bureau of Labor Statistics, and National Bureau of Economic Research, analyze data about spending and saving to determine MPC and at what point aggregate expenditure is equal to income.

At this point, the level of real GDP can be considered a healthy equilibrium, and the government does not need to use monetary or fiscal policies to encourage or discourage production.

Output-Expenditure Model Formula

The output expenditure model formula considers the relationship between the real GDP and the total consumption taking place in the economy.

The output-expenditure model formula is pretty straightforward. It is basically aggregate expenditure equal to real GDP:

While the real GDP might be relatively easy to measure and check whether it is equal to aggregate expenditure, it is hard to calculate aggregate expenditure.

Aggregate expenditure is calculated using the formula:

MPC is also considered in the output-expenditure model as it affects and determines the aggregate expenditure.

Keynesian Expenditure Output Model

The Output-Expenditure Model is also known as the Keynesian cross model.

Classical economists like Adam Smith and John Baptiste Say did not believe excessive production was harmful to the economy. Say's Law argued that "supply creates its own demand", meaning that everything produced would be consumed.

Thus, overproduction was only a very temporary phenomenon. By producing more things, workers would get paid more wages and could buy more items. Also at work was the belief in flexible prices and wages, which saw prices and wages rise and fall in direct proportion to supply and demand. Any excess production would result in a corresponding drop in product price until consumers purchased it all.

However, the Great Depression of the 1930s made classical economic theory unpopular. Markets were not self-correcting based on the supply and demand laws, and goods' surpluses were building up.

Economist John Maynard Keynes believed that firms would not simply continue to produce when faced with surpluses and would reduce their output. Keynes thought that the government should try to increase aggregate demand (aggregate expenditures) to the point where the excess supply was consumed.

This was accomplished in the United States with New Deal policies, which saw the use of expansionary fiscal policy to boost spending. This government spending plan increased aggregate expenditure and thus increased the equilibrium GDP, allowing a more significant amount of output to be consumed.

The Output Expenditure Model - Key takeaways

  • The output-expenditure model compares aggregate expenditures (total demand) to gross domestic product (real GDP).
  • The output expenditure model considers the following aggregate spending:
    • consumer spending
    • investment spending
    • government expenditure
    • net exports
  • Aggregate expenditure equal the total spending in the macroeconomy.
  • The output-expenditure model formula is pretty straightforward. It is basically aggregate expenditure equal to real GDP.

Frequently Asked Questions about Output Expenditure Model

The output-expenditure model compares aggregate expenditures (total demand) to gross domestic product (real GDP). 

By using the following formula: GDP = C + I + G + (X-M)

In the net exports part of the aggregate expenditure.

It's an economics model that explains the relationship between aggregate consumption and real GDP.

Aggregate expenditure is equal to aggregate income, thus the equation becomes: AE=Y

Final Output Expenditure Model Quiz

Question

What is the output expenditure model?

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Answer

The output-expenditure model compares aggregate expenditures (total demand) to gross domestic product (real GDP).

Show question

Question

What is real GDP?

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Answer

Real GDP represents the total output in the economy. It is the full value of all final goods and services produced within a nation, adjusted for inflation (rising prices).  


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Question

What are the components of aggregate expenditure?

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Answer

Consumer spending, investment spending, government expenditure, and net exports

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Question

What does personal consumption consist of?

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Answer

Personal consumption expenditures consist of nearly everything consumers purchase, including food, rent, and almost anything else. 

Show question

Question

What does the investment sector entail?

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Answer

The investment sector, often known as the business sector, is responsible for the spending of the money generated by the economy on workers, factories, equipment, inventories, and other economic investment items. 

Show question

Question

How does the government spend its money?

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Answer

The government allocates its revenue to a wide variety of priorities, such as national defense, social security, interest payments on the national debt, health care, and the construction of highways.

Show question

Question

What does it mean for real GDP to be equal to aggregate expenditure?

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Answer

It means that all of the production is consumed.

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Question

Explain the 45 degree line.

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Answer

The 45-degree line represents the real GDP, a straight line that starts from the origin and continues outwards

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Question

Why the level of consumption and production is equal through the 45 degree line?

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Answer

The reason is that there's as much total production (real GDP) as consumption at every point on the line

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Question

What is the potential GDP line?

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Answer

The potential GDP line refers to the total possible production if the economy uses all of its resources. 

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Question

Where is equilibrium real GDP formed?

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Answer

At the point where the AE line intersects the 45-degree line forms the equilibrium real GDP in the output expenditure model.

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Question

What happens when the 45 degree line is below AE?

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Answer

When output, represented by the 45-degree income line, is below aggregate expenditures (AE), an inflationary gap occurs due to aggregate demand (synonymous with AE) being greater than supply.

Show question

Question

What happens when the 45 degree line is above AE?

Show answer

Answer

A recessionary gap occurs due to supply being greater than demand. Firms will restrict their output to avoid an accumulation of unsold inventory.

Show question

Question

What is the marginal propensity to consume?

Show answer

Answer

The marginal propensity to consume shows the part of income households consume rather than save.

Show question

Question

Why AE line is not always equal to the 45 degree line?

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Answer

The reason is that aggregate expenditure depends on the Marginal Propensity to Consume (MPC), meaning that individuals don't consume all their income.

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